Hussein Abdallah looks at the ups and downs of oil prices and what the future might hold After reaching $68 in July and August, oil prices -- as represented by OPEC Reference Barrel (ORB) -- tended to fall in recent weeks at an average price of $55. In a move to bolster oil prices and guard against any further decline, OPEC ministers met in Doha, Qatar on 19-20 October and decided to cut the group's oil output by 1.2 million barrels per day. The move gives rise to the question: is the price drop a trend, as some Western authorities tend to believe, or is it just a temporary happening ? In order to forecast where the price is going, it is necessary to understand where it is coming from. In the wake of the Arab victory in the October 1973 War, oil prices were corrected in 1974 from the unjustifiable low rate of $3 per barrel to the more reasonable price of $11.65. Five years later following the Iranian Revolution, oil prices peaked at $33 per barrel. However, Western industrial countries, who were and continue to be the major oil importers, succeeded in restoring their control of oil markets by coordinating their energy policies, both individually and collectively. A major element in this coordination was the establishment of the International Energy Agency (IEC), which aimed to counter the rising power of OPEC. Accordingly, oil prices gradually relaxed in the first half of the 1980s, then collapsed from $28 to $13 in 1986. By 1987, oil prices settled at around $18 and continued to hover around this figure until 2000. While the prices of goods and services imported by oil-exporting countries from industrial countries increased between 1987 and 2000, the price of oil remained at around $18. This rendered the real price of oil at $4.50 per barrel, only slightly above the pre-1974 price. While oil prices fell, the taxes imposed by industrial countries on petroleum products increased, feeding their treasuries. In Europe, oil taxes leapt from an average of $22 in 1986 to $65 per barrel for petroleum products in the 1990s, which is equal to approximately 70 per cent of the retail price for consumers. In a move aimed at partially recovering the eroded value of oil prices in 2000, OPEC adopted a price band mechanism which resulted in an average price of $25 per barrel in 2000-2003. Yet, this nominal price was still no more than $5.15 in real terms. The unexpected hikes in oil prices since 2004 revealed the serious deficiencies that plague the oil industry as a result of the decline of the nominal and real price of oil, reflecting its eroded purchasing power. Consequently, the volume of investments aimed at expanding oil producing capacity deteriorated, and the unprecedented increase in world oil demand of 6 million barrels per day over the period 2003-2006 failed to be met by adequate spare oil capacity. The search subsequently began for a new price band that would be both fair and acceptable to producers and consumers, and which provided sufficient returns to the international oil companies (IOCs). Such returns would encourage them to explore for oil and expand their oil producing capacity. Western industrial countries traditionally opposed discussing the price issue in the context of a dialogue between producers and consumers. This was their attitude during the North-South Dialogue held in Paris from January, 1976 through June, 1977 , at which the author of this article was one of the 15 Energy Commission Members. The oil producers- consumers dialogue was revived in 1991 in the form of informal and non-binding talks, and continued to be held until it was institutionalised in 2002 as the International Energy Forum (IEF). Saudi Arabia volunteered to host a permanent secretariat for the IEF whose headquarters was inaugurated in Riyadh on 19 November, 2005. According to a Merrill Lynch report published in April, 2004, the failure to secure oil investments is due to the inability of the capital expenditures by both national and international oil companies to keep pace with the increased cost of oil exploration, which has snowballed at an average rate of 10 per cent annually since the mid-1990s. To stimulate investment in the oil industry, the price of oil had to be raised so as to preserve the reasonable average rate of return at 13 per cent. In the mid-1990s, the investment needed to secure a production capacity equal to one barrel per day over a period of ten years was estimated to be $14,600. The capital cost of finding and developing oil was approximately $4 per barrel, accommodating the 13 per cent rate of return, based on the 1990s prevailing price of $18. From 2001 to 2003, the volume of investment required to secure the same production capacity surged to $25,600, raising the capital cost of finding oil to $7 per barrel. This necessitated a price elevation to $28 in order to maintain the 13 per cent rate of return. While global demand for oil is anticipated to increase from the current 85 million barrels per day (mbd) to 125 mbd by 2030, the investments needed to expand oil and gas production in the Middle East over the next 25 years is estimated at $750 billion. This prompts the question of what price will suffice to encourage investment in expanding oil production capacity towards serving consumer needs, and guarding against price shocks. The OPEC oil price jumped from an average of $25 per barrel over the period 2000-2003 to $36 per barrel in 2004, and to $50 in 2005. It is expected to reach $62 in 2006, including a fluctuating margin attributed to the troubled geopolitics in the Middle East, especially the US occupation of Iraq. Under normal geopolitical conditions, the ORB price should be allowed to gradually increase over time, in accordance with an annual rate determined by three principles previously adopted by agreements with IOCs. Two are endorsed in the 1971 Tehran Agreement between OPEC and IOCs. First, a gradual 2.5 per cent annual price increase to cover inflation; second, an annual increase of $0.05 as a special allowance because oil is a non-renewable resource that will soon be depleted in the light of heightened demand. In 1971, the $0.05 represented 2.5 per cent of the price of oil, which hovered at around $2 per barrel. Accordingly, the annual rate of increase adopted by the Tehran Agreement was approximately 5 per cent. Although the Tehran Agreement is no longer valid, these two principles are still applicable as logical indicators. The third principle is embodied in the first Geneva Agreement of 1971 with IOCs. It stipulates correcting oil prices in accordance with value variations of the US dollar, which is used to post oil prices, vis-à-vis other major currencies. After the decision to float the US dollar on 15 August, 1971, and its subsequent official devaluation on 17 December, 1971, the price of oil accordingly rose by 8.5 per cent starting 20 January, 1972. When the US dollar was devalued again on 12 February, 1973, the second Geneva Agreement, concluded in June, 1973, endorsed an approximate price increase of 11.9 per cent and provided for monthly price adjustment in light of the currency's fluctuations. These three principles should be taken into account in the estimation of the nominal annual increase in oil prices. Even if the US dollar fluctuations vis-à-vis other major currencies eventually equalise in the long run, the annual rate of price escalation would not be less than 5 per cent over the past thirty years, according to the two principles of the Tehran Agreement. Price escalation needs to start at a basic year. The price of $11.65 that was adjusted after the October War is a fair price suitable to serve as a basis for gradual escalation, as well as a means to compensate for the erosion of the real price of oil. Therefore, on the basis of the above three principles for estimating the composite annual rate of price increase (5 per cent) over the past thirty three years, the nominal price of ORB should not fall below $58 at present. However, due to troubled geopolitics and/or stock and seasonal fluctuation of oil demand and supply, the price of oil may be driven to much higher levels depending on the severity of the effect. This new price of $58 under normal conditions, and upgradeable over time according to the three principles of the inflation rate, demand growth rate, and fluctuation of the US dollar value, stands to provide international oil companies with a fair profit to encourage expanded investment, and the proprietors of oil reserves with a reasonable share of oil rent to compensate them for the ultimate depletion of oil -- their sole source of primary income.
